A Citizen’s Guide to Interest Rates

What most people don’t know about what really makes our economy go.

(…… but should)

The Secret Life of Interest Rates

• The most important thing that interest rates do is to act as signals for the market.

• Signal to save or borrow and spend.

• ir also serve to ration the available supply of money to those who are willing and able to use it most efficiently in the long run.

• Act as an automatic stabilizer to inflation.

Rationale• Much of the internal doings of the U.S. (and

World) economy have to do with monetary and fiscal policy decisions which affect interest rates.

• Any understanding of Economics is incomplete without knowledge of how interest rates affect and are affected by every other component of the economy.

• Savings and Investment in Capital are where the individual interfaces with these policies.

• Most individuals understand interest rates imperfectly if at all.

Key Topics Regarding ir• Identify models that should be used to

demonstrate economic theories and discuss when to use which model.

• Identify important concepts and how to apply them.

• Discuss ir using appropriate vocabulary balancing jargon with concrete explanations in plain English.

Key Concepts• What are Interest Rates?• Real vs. Nominal• Money Supply and the Federal Reserve• Money Demand• Loanable Funds Market• Fiscal policy and its impact on interest rates• Crowding-Out Effect• Bond Market• Foreign Capital Injections and Leakages

The Relation Between Capital Investment and Interest Rates

• Interest Rates DETERMINE the quantity of Capital Investment and Savings in the Economy.

• Interest is the Opportunity Cost or “Price” paid for the use of money

• Borrowers pay lenders for money to be used now, and repay later with interest

• Savers earn interest because they are letting a lender use their money now

• Lenders are financial intermediaries.• Interest rate is stated as a percentage

Real ir vs. Nominal ir• Appropriate abbreviations for Interest rate

include “ir”, “i”, and “r” (always lower-case)

• Nominal: loosely means “in name only”

• Nominal ir discussed in terms of current price level

• Real: loosely means “adjusted for inflation”

• Real ir discussed in terms of actual purchasing power.

How Nominal and Real Relate

• (Calculate) Nominal ir

– Inflation Rate

= Real ir

• If Nominal ir goes up, Real ir doesn’t necessarily increase.

• If Real ir goes up, Nominal ir will follow.

Graphic Models for ir• Interest rates play a role in various graphic

models, the key is to figure out if they are nominal or real ir.

• The Money Market Model is used to discuss the supply of money as defined by the FED. (nominal ir)

• The Loanable Funds Market is used to reflect the saving and borrowing habits of the private sector. (real ir)

Money Market Model• Used to target the

Fed Funds Rate through monetary policy.

• Nominal ir• Should be used in

conjunction with AD/AS and Investment Demand models (Next Slide)

Money Market Model

Nominal ir

ir

ir1

MS MS1

MD

QM QM1

Quantity of Money

Money Market Linked to Demand for Capital Investment

Expansionary Policy

MS MS1

MD

Nominal

ir

ir

ir1

QM QM1

Quantity of Money

Investment Demand

I

Nominal

ir

I I1

Quantity of Capital Investment

Investment Linked to AD/AS

Investment in Capital

Nom-inal

ir

I

ir

ir1

0 I I1

Quantity of Capital Investment

Price level

PL1

PL

Y Y1

SRAS

AD (C+I+G)

AD1

(C+I1+G)

Real Gross Domestic Product

Expansionary Policy

Loanable Funds Market• The Demand Curve for LF

represents private demand for Loanable Funds.

• The Supply Curve for LF represents private savings.

• LF model represents the real ir. (abbrev. “r”)

• Supply of LF (savings) sets the Prime Lending Rate.

• Government borrowing to cover deficit spending will move DLF to the right.

• Changes in the savings habits of the private sector shift SLF

Loanable Funds MarketReal ir

Quantity of Loanable Funds

DLF

SLF

r

QLF

Loanable Funds Theory of Interest

• The supply of loanable funds comes from savers who deposit money in banks.

• Supply is positively-sloped because people need an incentive to delay current spending.

• Demand is negatively-sloped since higher ir discourage borrowing and spending.

• Government borrows money from this market when taxes don’t cover the bills.

Control of Interest Rates• The majority of influence on interest rates comes

from the private sector.• Rates react to changes in the individual desire of

private citizens to consume or invest in capital. (or to save…)

• Investment spending and the interest sensitive components of consumption spending are inversely related to interest rates.

• The desire to save is positively related to ir.

Definitions of Money• The Money Supply is broken down into

three categories:M1: Cash, Currency, Checkable

Deposits, NOW accounts, etc… M2: Savings (under $100,000), Short time deposits, CD’s, MMF’s, etc…

M3: Deposits in excess of $100,000 and other long time deposits

The Demand for Money• This is a uniquely Macroeconomic

concept• At any given time, there is a finite

quantity of money in circulation (M2 is Inelastic).

• The transaction demand (M1) depends on GDP because incomes = expenditures.

Fiscal Policy• Most expansionary government spending

programs are financed through borrowing.

• Budget deficits will increase the demand for loanable funds and cause real ir to rise

• Contractionary fiscal policy will cause budget surplus

• Budget surplus will reduce the demand for money and reduce interest rates

Deficit Spending• Government demands loanable funds to

pay for deficit fiscal spending

• By increasing the D for LF, the real ir increases. Loanable Funds Mkt.

Qty. of Loanable Funds

Real ir

Crowding Out• The increased real ir caused by deficit

fiscal spending causes a decrease in private Investment spending and the interest-sensitive component of Consumption spending.

• This lost investment and consumption is said to have been crowded out.

• Crowding out is an effect, never a cause.

Crowding Out and AD/AS Deficit Fiscal Policy

SLF (Private Savings)

DLF (Private Demand)

DLF1 (Private + Government)

Real ir

r1

r

QLF QLF1

AD (C+I+G)

AD1

(C+I+G1)

AD2 (C+(I-I1)+G1)

Price Level

AD shifts to AD1 when G increases Then shifts back to AD2 as I falls due to the increase in interest rates.

Pl1 Pl2

PL

Y Y2 Y1

Quantity of Loanable Funds Real Gross Domestic Product

SRAS

Barro-Ricardo Effect• The Barro-Ricardo Effect is feedback caused by

a Crowding Out effect.• Higher interest rates associated with Crowding

Out cause individuals to save more of their incomes.

• The rise in savings increases the supply of loanable funds, thereby reducing the real interest rate.

• The B-R effect has a smaller impact and usually doesn’t fully negate a crowding out effect.

Monetary Policy• Money is Neutral: any changes of the money

supply can stabilize the economy.• Any attempt to grow the economy will result in

inflation.• At any moment, the money supply is fixed• The supply of money is controlled by the Federal

Reserve (the FED), using three main techniques.

• Discount Rate, Fed Funds Rate, & Required Reserve Ratio.

Expansionary and Contractionary Policy

• Expansionary Policies are used to increase the money supply (ex. Decrease RRR, Discount or Fed Funds Rate)

• Contractionary Policies are used to reduce the money supply (ex. Raise RRR, Discount or Fed Funds Rate)

• Interest rates increase and decrease in an inverse relationship with changes in the money supply.

The Discount Rate• This is the interest rate that banks pay to

borrow emergency cash from the FED

• Also known as the “Overnight” rate.

• Short term loans cover checkable deposits held by the banks and the FED.

• These are determined at the district level but are adjusted with input from D.C.

• The FED is the lender of last resort.

Required Reserves Ratio• Banks are required to retain some of their

deposits on hand in the form of vault cash or on deposit at a federal reserve bank.

• The quantity of reserve is determined as a percentage of checkable deposits.

• That percentage is called the RRR or Required Reserve Ratio.

• 1/RRR = Simple Deposit Expansion Multiplier• The multiplier determines the total growth of the

money supply from checkable deposits.

Fed Funds Rate• AKA the “Immediate rate”, it is the ir that banks

charge each other to borrow money• The supply of money relative to the demand for

it determines the ir.• The FFR is not set at a particular %, but is

“targeted” by changing the money supply through the purchase or sale of bonds on the open market.

• Buying bonds from the public pumps money into the economy, selling bonds takes money out of the system.

The Bond Market• Bonds are loans made to the government by

individuals and institutions with a guaranteed rate of return and a clearly defined time limit.

• Bond Prices and ir are inversely related• Governments (state, federal, and local) use the

sale of bonds to pay for deficit spending.• The FED buys and sells bonds to stabilize the

economy after deficit spending.• Bond rates send signals to both domestic and

international buyers.

Net Foreign Investment• High Interest rates in the U.S. encourage net

foreign investment in U.S. Bonds. D for $ rises, exports down, and imports up.

• Low Interest Rates in the U.S. discourage net foreign investment in U.S. Bonds. D for $ falls, exports up, and imports down.

• Increased Net Investment in U.S. Bonds is called Capital Inflow (or “Injection”).

• Decreased Net Investment in U.S. Bonds is called Capital Outflow (or “leakage”).